How to Survive a Recession

LESSON 19: Sell Stocks Short

Most investors believe that purchasing an asset and holding it for a long period is the path to wealth generation. When the economy is in moderate-to-good shape this is the best approach for most investors.

When a recession hits, stock markets drop rapidly—much faster than they gain value in good economic times. There are two reasons for this. First, existing stock holders sell their shares in a panic trying to get their cash out before it’s too late. Second, large institutional investors responsible for over 50% of the market drive the stock market down. They sell earlier than the general public as fundamentals begin to deteriorate, then they short the market, betting on the panic to follow. Looking at the Nasdaq market in 2000 shows just how quickly markets capitulate under all this selling pressure.

A short stock sale is simply a bet that price will drop. All you need is a margin account, which most brokers provide automatically to their clients. The mechanics of a short sale work like this: a) you borrow shares of Stock X from somebody that owns it, using your broker as the intermediary (this is seamlessly handled by the broker); b) you then sell those shares of Stock X on the open market at, say $50 each; c) you wait for the price to drop, d) you repurchase the shares at a lower price at say $24 each; and d) you deliver the shares back to the original owner via your broker which repays the stock loan and allows you to pocket the difference in price.

It is possible to short almost any asset, including stocks, bonds, options, exchange-traded funds (ETFs), closed-end funds or trusts, futures, currencies, and commodities. Many exchanges have limitations on shorting to prevent major market players from causing sudden crashes. Unless you are a big day trader, however, these rules are unlikely to prevent you from selling short and profiting from market downturns.